Forex Exposure and Risk

1. Forex Exposure and Risk International Corporate Finance P.V. Viswanath

2. Learning Objectives • What is foreign exchange exposure? • What is foreign exchange risk? • How do we measure foreign exchange risk and foreign exchange exposure? • What factors contribute to risk and exposure? P.V. Viswanath

3. Foreign Exchange Exposure • Foreign Exchange exposure is the sensitivity of real US-dollar values of assets or liabilities with respect to unanticipated changes in exchange rates. • Foreign exchange exposure = V/e • How the value of an asset/liab changes for a unit change in the exchange rate. • Suppose, we use the euro as the foreign currency. • Then, since the denominator is measured in $/€, and the numerator is measured in $, exposure, therefore, is measured in terms of the foreign currency. P.V. Viswanath

4. Forex Exposure on Assets/Liabs • Contractual assets or liabilities are those with domestic-currency values • Exposure on a contractual asset or liability equals the value of the asset or the liability. • Suppose there is a bank deposit of €1,000. • Suppose, again, that the exchange rate moves from $1.2572/€ to $1.2577/€. Then the $value of the bank deposit will change from $1257.2 (1,000x1.2572) to $1257.7 (1000x1.2577). • Hence the amount of the exposure works out to (1257.2-1257.7)/(1.2572-1.2577) = €1,000. P.V. Viswanath

5. Exposure for Contractual Assets/Liabs • The positive sign indicates that an increase in the exchange rate (appreciation of the foreign currency) causes a increase in the dollar value of the asset. • Hence we say that the asset represents a long euro position. • Long foreign exchange exposure is when an investor gains when the foreign currency rises and loses when the foreign currency declines. Short exposure is when the opposite happens. P.V. Viswanath

6. Exposure on a non-contractual asset • Suppose a US investor holds shares in PPR S.A. (formerly known as Pinault-Printemps-Redoute) shares, traded in France. The current price (June 19, 2006) of the stock is €97.75, which works out to $122.89 at the current exchange rate is $1.2572/€. • The group owns brand names such as Gucci, YSL and Boucheron. According to Yahoo, 12% of its sales are in the US. • Suppose the exchange rate rises to $1.2577/€. Since PPR’s products would cost more in the US, its US sales would drop and hence the stock price might suffer. • Suppose the price is expected to drop to €97.65, or $122.81 (97.65x 1.2577). • Then, the exposure would be (122.81-122.89)/(1.2577-1.2572) or -€160 P.V. Viswanath

7. Exposure on a non-contractual asset/liab • Exposure on a foreign asset or liability can be higher or lower depending on the correlation between the local-currency value of the asset/liability and the exchange rate. • Exposure can be higher than the foreign-currency value if the local-currency asset price and the exchange rate move in the same direction. • This can happen with investments in foreign import-oriented companies that become more profitable when the importer’s domestic currency appreciates, and less profitable when the importer’s currency depreciates. • The reverse is also possible with investments in foreign export-oriented companies that become more profitable when the domestic currency falls. P.V. Viswanath

8. Forex exposure in bonds • An investor in foreign-currency bonds is exposed by more than the value of the bonds if the foreign central bank “leans against the wind.” • This means that the central bank raises interest rates when the home currency depreciates and vice-versa. • Domestic currency-denominated bonds can be exposed to exchange rates if the home country central bank leans against the wind. If interest rates affect stock prices, the domestic stock market as a whole is also exposed. P.V. Viswanath

9. Measuring forex exposure • Exposure can be measured by the slope coefficient in a regression equation relating the real change in the dollar value of assets/liabilities to changes in exchange rates. • For exposure to exist, dollar values must on average change in a particular way vis-à-vis unanticipated change in exchange rates. • When exposures exist against several currencies, they can be measured from the slope coefficients in a multiple regression. P.V. Viswanath

10. Euro exposure of an investor in DCX • I recorded the daily share price of Daimler-Chrysler from June 16, 2003 to July 1, 2004 (Yahoo) and computed the daily return. • I then took the change in the € exchange rate and regressed the former (DCX return) against the change in the exchange rate, and obtained: • RDCX = 0.000162 – 0.01912 (%e) • N = 217, R2 = 0.002, t-stat for slope = -0.628 • No evident exposure • How do we interpret this? 52% of DCX’s sales are in the US and 33% in Europe (Yahoo). P.V. Viswanath

11. Forex Risk • Forex risk is measured by the standard deviation of domestic-currency values of assets or liabilities attributable to unanticipated changes in exchange rates. • It can be computed as .(eu) • If the foreign currency is the €,  is measured in €, eu and hence (eu) are measured in $/€; hence risk is measured in $ units of volatility. • In our case, (eu) = 0.016219; hence .(eu) = (0.01912)(0.016219)*365 = 11.32% per year. • Keep in mind, however, that the t-statistic is much below 2.0 P.V. Viswanath

12. Forex Risk and IRP • Foreign exchange risk is positively related to both exposure and the standard deviation of unanticipated changes in exchange rates. • When a foreign currency-denominated security is not hedged with a forward exchange contract, it is exposed, irrespective of whether interest rate parity holds. • If IRP holds, a $1 investment in the euro, appropriately hedged, will generate (f1/e0)(1+r€); if IRP holds, this will equal (1+r$). There is no exposure, due to the hedging. • However, if we have not hedged our exposure, then there will be exposure, whether or not IRP holds, equal to (1/e0)(1+r€) and forex risk equal to (1/e0)(1+r€).(eu). P.V. Viswanath

13. Forex Risk and PPP • On the other hand, if PPP holds, there will be no exposure. • This is because, according to PPP, P$ = e.P£ • If exchange rates change, foreign prices are going to adjust so that domestic values do not change. • If individual asset values do not always change by the overall rate of inflation for a country but on average change at the rate of inflation, exposure is zero if PPP holds on average. • With random departures from PPP, there is an added source of risk but this is part of the total risk, not the foreign exchange risk. P.V. Viswanath

14. Operating Exposure • The sensitivity of operating income to changes in exchange rates is called operating exposure and the standard deviation of operating income due to unanticipated changes in exchange risk is called operating risk. • If PPP always holds exactly and market prices and production costs always move in line with overall inflation, there is no operating exposure or operating risk. If PPP holds only on average and prices and production costs move on average at the overall rate of inflation, there is still no exchange rate exposure or risk, but there is greater total risk. P.V. Viswanath

15. Operating Exposure and PPP • Consider a UK firm exporting to the US. His profits in $ equal  = (ep£-c$).q • Suppose the exchange rate changes. Then, assuming that there is no impact on q, we have: • /e = q[p£+ep£/e] • If PPP holds, then p£/e = -p$/e2. Substituting above, we see that /e = q[p£-p$/e] = 0. • Hence if PPP holds, then there is no operating exposure. • If, however, an individual company’s prices and costs do not change at overall inflation rates, then there will be operating exposure, even if there are no overall deviations from PPP. P.V. Viswanath